June 11 (Bloomberg) -- XL Capital Assurance Inc. must honor $3.1 billion of guarantees on collateralized-debt obligations after Merrill Lynch & Co., the third-largest U.S. securities firm, won a court ruling against the bond insurer.

U.S. District Judge Jed Rakoff in Manhattan yesterday granted Merrill's request to force the unit of Security Capital Assurance Ltd. to honor the default protection on $3.1 billion of CDOs, which repackage bonds and other assets into new securities. Rakoff said in a one-page ruling that Merrill's motion ``is granted in all respects.'' The judge said he'd issue an opinion later setting forth his reasons.

``The real stunner would have been if the case had gone the other way,'' Paul Jorissen, a structured-finance partner at law firm Mayer Brown in New York, said in an interview. ``It would have raised the specter that significant amounts of other policies would be open to a similar attack,'' said Jorissen, who isn't involved in the case.

Merrill won declarations from the judge that it hadn't repudiated its obligations under seven credit-default swaps it entered with XLCA and that XLCA's purported terminations of those swaps ``are without effect,'' Rakoff said. Merrill also won dismissal of three of four XLCA counterclaims.

``The company disagrees strongly with yesterday's result, intends to continue defending its legal position and is evaluating its options for appeal,'' SCA spokesman Michael Gormley said in an e-mailed statement. He said the ruling was made ``without the benefit of SCA being permitted to complete discovery, which cut short the company's opportunity to fully investigate and support its claims.''

Anticipated Claims

SCA's best estimate for anticipated claims under the contracts was $428.9 million as of March 31, up from $417.3 million in last year's fourth quarter, Gormley said.

``We're pleased with the court's ruling,'' Merrill spokesman Mark Herr said.

Mortgage-bond CDOs have been the largest source of the more than $392 billion of writedowns and losses reported by the world's largest banks and securities firms since the beginning of last year. Losses might rise if default protection bought from companies such as the XLCA unit of Hamilton, Bermuda-based SCA fails to pay off.

In March, XLCA defended its decision to cancel the swaps, arguing Merrill breached agreements by shifting control rights to at least one third party, XLCA competitor MBIA Inc. Merrill said it hadn't entered any agreements that would preclude it from fulfilling XLCA's contracts.

CDO Tiers

Merrill argued that, even though Armonk, New York-based MBIA was covering CDO tiers more senior to those insured by XLCA, the bank could still vote the shares according to XLCA's directions. A ruling in XLCA's favor ``would have represented a misconstruing of how the voting provisions are supposed to work,'' Jorissen said.

Merrill contracted with MBIA last year when it was ``desperate to get more CDO liabilities off its books,'' XLCA said in court papers. For its part, the bank said the decline in the credit markets caused XLCA to have ``sellers' remorse,'' causing it to seek to avoid ``potential obligations of up to approximately $3.1 billion under the credit-default swaps.''

The debt with XLCA policies that Merrill bought last year includes classes of West Trade Funding II Ltd., Silver Marlin CDO I Ltd. and Jupiter High-Grade CDO VI Ltd.

Credit-default swaps offer payments if the securities aren't repaid as expected, in return for regular insurance-like premiums.

Merrill filed its lawsuit on March 19. It was represented by Jay Kasner and Scott Musoff of Skadden, Arps, Slate, Meagher & Flom in New York. XLCA was represented by Peter E. Calamari and Jonathan E. Pickhardt of Quinn Emanuel Urquhart Oliver & Hedges in New York.

Merrill is a passive, minority investor in Bloomberg LP, the parent of Bloomberg News.

The case is Merrill v. XLCA, 08-cv-2893, U.S. District Court, Southern District of New York (Manhattan).

To contact the reporter on this story: David Glovin in Manhattan federal court at dglovin@bloomberg.net; Thom Weidlich in Manhattan federal court at tweidlich@bloomberg.net.

Last Updated: June 11, 2008 12:02 EDT